Key Takeaways
- Upside means potential gains beyond expected returns.
- Kotlikoff's strategy secures spending floor with safe assets.
- Risk portion targets growth, protecting essential income.
- Upside capture ratio measures gains relative to market.
What is Upside?
Upside refers to the potential for an investment to increase in value beyond its expected return, representing the favorable outcome or gain you might achieve. In investing, understanding upside helps you evaluate opportunities where assets could outperform benchmarks, such as the S&P 500.
Some strategies, like factor investing, focus on capturing upside while managing risk to improve returns over time.
Key Characteristics
Upside has distinct features that influence your investment decisions:
- Potential for Gains: Reflects the best-case scenario where assets appreciate beyond forecasts, often measured by metrics like upside capture ratio.
- Risk-Reward Balance: Upside is weighed against downside risk, with strategies aiming to maximize gains while limiting losses.
- Volatility Sensitivity: Growth sectors, including technology, typically offer higher upside but with increased volatility.
- Guaranteed Floor Concept: Some approaches, like Kotlikoff's upside investing, secure a base living standard with safe assets, such as Treasury Inflation-Protected Securities (BND), before seeking upside.
- Asymmetric Returns: Funds can capture more upside than downside, improving long-term outcomes compared to broad market indexes like IVV.
How It Works
Upside investing involves allocating a portion of your portfolio to higher-risk assets for growth, while securing a spending floor with low-risk securities. By assuming the risky assets could lose all value, you protect your essential spending through safe investments.
For example, you might invest a set percentage in stocks and the remainder in inflation-protected bonds, gradually converting stocks to bonds as you approach spending milestones. This method reduces sequence-of-returns risk and ensures stable income, contrasting with traditional rebalancing and bucketing strategies.
Examples and Use Cases
Various investors and sectors apply upside principles to balance growth and security:
- Airlines: Companies like Delta and American Airlines often experience upside during economic recoveries, providing opportunities for gains beyond expectations.
- Index Funds: Low-cost funds tracking indexes such as SPY or IVV capture broad market upside but may also expose you to full downside risk.
- Retirement Planning: Incorporating upside investing strategies with a secured floor aligns with retirement tools like a 401(k) plan, balancing growth potential with spending safety.
Important Considerations
While pursuing upside, ensure you maintain discipline by not spending from your risk bucket and protecting your base spending level. Be aware that upside capture ratios vary, and funds with asymmetric returns can help reduce recovery times after market downturns.
Additionally, understanding concepts like tail risk and employing objective probability assessments can improve your evaluation of potential gains versus losses. Using tools to simulate allocations and spending floors can further optimize your upside exposure while managing downside risks.
Final Words
Upside investing balances security with growth by ensuring a guaranteed spending floor while capturing market gains. To protect your retirement income, consider calculating your safe asset allocation first, then allocate remaining funds to growth opportunities prudently.
Frequently Asked Questions
Upside in investing refers to the potential for gains beyond expected returns. It represents the favorable uncertainty where an asset or investment outperforms forecasts or market benchmarks.
Upside Investing is a low-risk strategy developed by economist Larry Kotlikoff that secures a guaranteed base living standard using safe assets like TIPS, while allocating a portion of funds to stocks for potential growth. This approach protects your essential spending even if stocks lose value.
The strategy assumes stocks could go to zero and only allows spending from the safe asset 'floor' funded by TIPS or similar securities. Stocks are gradually converted into safe assets, ensuring that the base living standard is maintained regardless of market downturns.
The upside capture ratio measures how much of a market's gains an investment captures during upswings. For example, a ratio of 120% means the investment outperforms the market by 20% in rising markets, helping investors identify funds that effectively capture upside potential.
Unlike traditional bucketing, which separates assets but may spend from risky buckets, Kotlikoff’s Upside Investing integrates precise spending rules that restrict withdrawals to safe assets only. This avoids sequence-of-returns risk and ensures permanent shifts from stocks to safety without rebalancing back.
Retirees or conservative investors seeking growth with strong downside protection benefit most. The strategy balances safety by securing a sustainable base living standard while still allowing for upside growth from stocks.
Implementation involves allocating a portion of your portfolio (e.g., 20-50%) to stocks and the remainder to safe assets like TIPS. You then spend only from the safe asset portion and gradually convert stocks into safe assets to raise your spending floor over time, following a disciplined plan like the one in the MaxiFi Planner software.
